Friday, August 2, 2019

Barro’s Misstated Case for Federal Reserve Independence

I guess I should applaud Robert Barro for standing up for the independence of the Federal Reserve and hoping it can resist political pressure to lower interest rates too much. But there are two aspects of his case that strike me as silly to say the least starting with his opening sentence:
In the early 1980s, the chairman of the US Federal Reserve, Paul Volcker, was able to choke off runaway inflation because he was afforded the autonomy necessary to implement steep interest-rate hikes.
This statement glosses over the fact that we had a macroeconomic mess in 1982. This mess was in part to blame on an ill advised fiscal stimulus initiated the moment St. Reagan took office. But clearly the Federal Reserve overreacted. To be fair – Barro continues his magical history tour in a reasonable way until we get this absurdity:
one could infer the normal rate from the average federal funds rate over time. Between January 1986 and August 2008, it was 4.9%, and the average inflation rate was 2.5% (based on the deflator for personal consumption expenditure), meaning that the average real rate was 2.4%. The long-term normal real rate can be regarded as an emergent property of the real economy. From an investment and saving standpoint, economic equilibrium balances the benefit from a low safe real interest rate (which provides low-cost credit for investors) against the benefit from a high real rate (which implies higher returns for savers). In the Great Recession, the federal funds rate dropped precipitously, reaching essentially zero by the end of 2008. That was appropriate, owing to the depth of the crisis. But what few expected was that the federal funds rate would remain close to zero for so long, through the end of then-Fed Chair Ben Bernanke’s term in January 2014 and beyond.
While it is nice that one conservative economist has finally decided that the low interest rates policies during the Great Recession were appropriate and not the harbinger of hyperinflation, Barro seems to be saying the long-run real interest rate has been the same for the last 23 years. There has been a lot of research to suggest otherwise. Rather cite all of this research, let’s just check out the interest rate on the 10-Year Treasury Inflation-Indexed Security, which used to hover around 2 percent before the Great Recession but is now less than 0.3 percent. I agree with Barro that the Federal Reserve should resist Donald Trump’s push for significantly lower interest rates at this time but I also hope that the Federal Reserve resists the temptation to increase real interest rates as much as Barro’s devotion to some 23 year average would suggest.

4 comments: said...

It was not Reagan who gave Volcker his independence to crack inflation. It was Jimmy Carter who appointed him in 1979, with Reagan basically not taking it away like Trump wants to do now to Powell's Fed, even as RR screwied the pooch by doing his stimulative fiscal policy that led to really jacked up interest rates.e

Carter is quite the contrast with Trump, with Carter in effect accepting that he might be facing a slow economy when he would be up for reelection in 1980 as a price of breaking the rising inflation. Of course we are not facing rising inflation now, but Trump pushing is threatening Fed independence so he can get as far away from a Carter reelection scenario as possible.

pgl said...

An interesting follow-up on how Reagan did try to pressure the Volcker FED: said...

Well, of course Volcker stopped in August, 1982 and cut rates, but that coincided with an aagreement from RR to raise taxes, or more accurately, cancel some planned tax cuts. This was triggered by the combo of recession and Mexico threatening to default on debts to major US banks. It was also the low point of the stock market, the time to buy, with the Dow at not much above 700.

pgl said...

DeLong referred some debate between Robert “no relationship to Paul Samuelson” and Paul Krugman on this topic:

DeLong also dug up some NY Times pieces during 1982 on the talks between the FED and the White House. I know Barro just skipped over all of this in his oped but this stuff is a must read.